Original title: Restaking: Everything Old is New Again
Original author: David Han
Original source: coinbase
Compiled by: Ladyfinger, Blockbeats
Editor’s Note:
Ethereum's Restaking protocol and LRT are becoming a hot topic in the cryptocurrency space. With the PoS consensus mechanism and the largest security fund in the crypto world with an economic security fund of nearly $112 billion, the concept of restaking provides a new way to contribute to network security while earning additional rewards. The successful launch of Eigen Layer and its rapid rise to the second largest DeFi protocol further demonstrates the potential and appeal of the restaking concept and technology.
The re-staking protocol not only provides a channel for validators to earn additional income by allowing them to re-stake their staked ether to secure new active validation services (AVS), but also brings new security and financial momentum to the entire Ethereum ecosystem. However, as LRT develops and the complexity of the re-staking mechanism increases, new risks emerge. These risks not only involve security and financial stability, but also include potential impacts on the stability of the future Ethereum consensus protocol.
Preface
The PoS consensus mechanism is the largest economic security fund in crypto, totaling nearly $112 billion. But validators who secure the network are not relegated to earning base rewards only on locked ETH. Liquidity Staking Tokens (LSTs) have long been a way for participants to bring their ETH and consensus layer earnings into the DeFi space - either to trade or re-collateralize in other transactions. Now, the advent of recollateralization has introduced another layer in the form of liquidity re-collateralization tokens.
Ethereum's relatively mature staking infrastructure and excessive security budget have enabled Eigen Layer to grow into the ecosystem's second-largest DeFi protocol with $12.4 billion in total value locked (TVL). Eigen Layer enables validators to earn additional rewards by reusing their ETH holdings to earn active validation services (AVS). As a result, middlemen in the form of liquid restaking protocols have also become more common, driving the proliferation of light rails.
That said, restaking and LRTs may present additional risks compared to existing staking products from both a security and financial perspective. These risks may become increasingly opaque as the number of AVS increases and LRTs differentiate their operator strategies. Nonetheless, restaking (staking) rewards are laying the foundation for a new class of DeFi protocols. Separate discussions on reducing staking issuance to a minimum viable issuance (MVI) could also further increase the relative importance of long-term heavy yields if such proposals are implemented. As a result, a heightened focus on restaking opportunities is emerging as one of the biggest crypto themes this year.
Ethereum re-staking basics
Eigen Layer’s re-staking protocol went live on the Ethereum mainnet in June 2023, and AVSs will be launched in the next phase of its multi-phase rollout (2Q24). In effect, Eigen Layer’s re-staking concept establishes a way for validators to secure new features in Ethereum, such as data availability layers, rollups, bridges, oracles, cross-chain messaging, etc., potentially earning additional rewards in the process. This represents a new revenue stream for validators in the form of “security as a service”. Why has this become such a hot topic?
As the largest PoS cryptocurrency, ETH currently has a massive economic foundation for protecting its network from hostile majority attacks. However, at the same time, the relentless growth of validators and staked ETH has arguably exceeded what is necessary to protect the network. At the merge (September 15, 2022), 13.7 million ETH was staked, roughly enough to protect the network TVL of 22.1 million ETH at the time. As we begin publishing, there are now approximately 31.3 million ETH staked, a threefold increase in ETH-denominated terms, but Ethereum's TVL in ETH terms is actually lower today (than at the end of 2022) at 14.9 million ETH (see Figure 1).
The overabundance of staked ETH and the security, liquidity, and reliability of the underlying asset puts it in a unique position to help facilitate the security of other decentralized services. In other words, we believe that restaking as a concept is largely inevitable as an extension of the inherent value of ETH. However, there is no free lunch. To ensure the correctness of these services, restaking is used for behavioral verification and may be subject to staking or slashing penalties, similar to traditional staking. (That said, slashing will not be enabled when the first set of AVSs are released in 2Q24.) Also, as with staking, restaking operators will receive additional ETH (or AVS tokens) for their services.
Ethereum LRT
Eigen Layer’s TVL growth to date has been astounding, second only to Lido (Ethereum’s leading liquid staking protocol). Eigen Layer has accomplished this while retaining deposit caps for most processes, and before launching any live AVS. That said, it is difficult to decouple the ongoing need for restocking from user interest in short-term spot and airdrop farming. While the amount of restocked ETH may continue to grow in the long term as the protocol matures, we believe TVL could decline in the short term when spot farming ends, or if early AVS rewards are lower than expected.
Eigen Layer builds on the existing staking ecosystem by staking diversified base LST or natively staking ETH (via EigenPods). Programmatically, validators point their exit addresses to EigenPods to earn Eigen Points, which are redeemable for protocol rewards in the future. LST locked in Eigen Layer (1.5M ETH) accounts for about 15% of all LST, while overall ETH locked in Eigen Layer accounts for nearly 10% of all ETH used in staking (3M’s 31.3M ETH). (LST itself accounts for 43% of all ETH invested in the ecosystem.) In fact, we believe that the rebalancing after staking demand stabilizes after October 2023 is the reason for the recent interest in onboarding new validators. In February 2024, more than 2 million ETH of staking was added, coinciding with the suspension of the Eigen Layer deposit cap. In fact, some LST providers are increasing their target APYs as a way to leverage reinvested interest to attract new users to their own platforms.
Learning from the popularity of LST, a rich LRT ecosystem has developed, with over half a dozen protocols offering versions of liquid reload tokens with various points and airdrop schemes. Of the 3M ETH secured in Eigen Layer, approximately 2.1M (62%) is wrapped in secondary protocols. We have seen similar patterns before in the liquid staking market and believe that diversification of alternatives will be important as the industry grows.
In the long term, if native staked issuance declines due to increased stake participation (which reduces yields as more validators join), then restaking may be an increasingly important path to ETH yield. Separate discussions on reducing native staked ETH emission may further increase the relevance of restaking (although this is very early in the discussion stage).
That said, AVS’s yield is expected to be relatively low post-launch, which could pose challenges for LRTs in the short term. For example, Ether.fi, the largest LRT, charges a 2% annual platform fee on its TVL for “vault management.” However, not all LRTs have the same fee structure, and there’s room for competition in this regard. But if we use this 2% fee as a headline for calculating breakeven costs, AVS would need to pay around $200 million in annualized fees ($1.24 billion recalculated) for Eigen Layer’s security services to break even — more than Aave or Maker have collected in the past year. This raises the question of how much business AVS would need to generate in order to increase overall yields for ETH stakeholders.
The emergence of authentication services
As of today, no AVS has been launched on mainnet. The first AVS to be released (in early 2Q24) will be EigenDA, a data availability layer that can play a similar role to Celestia or Ethereum's blob storage. After the Dencun upgrade successfully reduced L2 fees by over 90%, we believe EigenDA will become another tool in the modular arsenal for cheaper L2 transactions. However, building or migrating L2 to utilize EigenDA is a slow process and may take several months to generate meaningful revenue for the protocol.
To estimate EigenDA’s initial yield, we can compare to Ethereum blob storage costs. Currently, about 10 ETH is used for blob transactions per day on many major L2s, including Arbitrum, Optimism, Base, zkSync, and StarkNet (see Figure 5). If EigenDA sees similar usage levels, the annualized rate of recalculated rewards would be about 3.5k ETH per year, equivalent to about 0.1% in additional rewards, based on our conservative estimates. Fees for the first few months may be even lower than this estimate, although adding multiple AVS could quickly increase yields.
Other AVS built in the Eigen Layer ecosystem include interoperability networks, fast finality layers, proof of location mechanisms, Cosmos chain security bootstraps, etc. The opportunity space for AVS is very broad and growing. Resellers can choose which AVS they wish to obtain with ETH collateral, although this process becomes increasingly complex with each new AVS.
Challenges and Strategies of LRT
This raises the question of how different LRTs will handle (1) AVS selection, (2) potential slashing, and (3) eventual token financialization. In traditional staking, the one-to-one mapping between validator responsibilities and revenue is clear, making LST a relatively simple matter, all things considered. But with restaking, the many-to-one structure adds some non-trivial complexity (and the diversity of LRT issuers) in how gains (and losses) are accumulated and distributed. LRTs pay not only base ETH staking rewards, but also rewards for earning a set of AVS. This also means that the potential rewards paid out by different LRT issuers will vary.
Currently, many LRT models have not been fully clarified. However, if there is only one LRT per project, all token holders in a given protocol may be subject to uniform AVS incentives and slashing conditions. The design of these mechanisms may vary from LRT provider to LRT provider.
One suggestion is to take a tiered approach, where LRT issuers can adopt a range of “high” and “low” risk AVS, although this would require the establishment of yet-to-be-defined risk criteria. Additionally, depending on the architectural design, token holders’ final rewards may still be paid out in all AVS, which we believe defeats the purpose of a risk-tiered framework. Alternatively, decentralized autonomous organizations (DAOs) could decide which AVS are chosen, but this calls into question who the key decision makers are in these DAOs. Otherwise, LRT providers could serve as interfaces to the Eigen Layer and allow users to retain decision-making power over AVS adoption.
Upcoming risks
However, at launch, the recounting process should be relatively simple for operators, as EigenDA will be the only AVS that can secure. However, a feature of the Eigen Layer is that ETH committed to one AVS can then be further spun to other AVS. While this can increase returns, it also increases risk. Submitting the same recounted ETH to multiple AVSs presents challenges when dismantling the hierarchy of slashing and claiming conditions between services. Each service creates its own custom slashing conditions, so there could be a situation where one AVS slashes the recounted ETH for misbehaving, while another AVS wishes to reclaim the same recounted ETH as compensation to a harmed participant. This could lead to eventual slashing conflicts, although as mentioned, EigenDA will not have slashing conditions at initial launch.
Further complicating this setup, Eigen Layer’s “pooled security” model — where AVSs leverage a common pool of staked ETH to secure their services — can be further customized through “attributable security.” That is, it is possible for individual AVSs to earn (additional) re-used ETH that is used only to secure their specific service — a form of insurance or safety net to pay premiums for the AVS. As a result, as more AVSs are launched, the role of the operator becomes more technically complex and the slashing rules become more difficult to follow. In addition to this re-staking complexity, the expansion of LRT abstracts away many of the underlying strategies and risks from token holders.
This is a problem because, ultimately, we think people will go where these LRT providers offer the highest rewards. LRTs may therefore be incentivized to maximize yields in order to gain market share, but these may come at the cost of higher (albeit hidden) risk. In other words, we think it is risk-adjusted rewards that are important, not absolute rewards, but it may be difficult to be transparent about this. This may lead to additional risk as LRT DAOs are incentivized to re-eat at most multiple times in order to remain competitive.
Additionally, if LRT payments are made entirely in ETH, LRT could also exert downward selling pressure on non-ETH AVS rewards. That is, if LRT needs to convert native AVS tokens into ETH (or equivalent) in order to redistribute rewards to LRT token holders, the accrued value of repurchases could be limited by recurring selling pressure.
In addition, LRT also has non-negligible valuation risks. For example, if there is an extended staking withdrawal queue (after Ethereum's Dencun Fork, the validator churn limit was reduced from 14 to 8), LRT may be temporarily displaced from its base value. If LRT becomes a widely accepted form of collateral in DeFi (e.g., LST in borrowing and lending protocols), this may inadvertently exacerbate liquidations, especially in low liquidity markets.
This assumes that these DeFi protocols are able to properly assess the value attached to LRT in the first place. In reality, LRT represents a diversified set of portfolio holdings whose risk profiles may change over time. New components may be added or removed, or the AVS themselves may change their yield or solvency risk. Hypothetically, we can see a scenario where a market downturn could affect several AVS simultaneously, destabilizing the LRT and amplifying the risk of forced liquidations and market volatility. Recursive lending would only amplify these losses. On the other hand, a protocol that is able to decompose LRT into its principle and yield components could help mitigate this risk, as the tokenized principal could be used as original collateral and the tokenized yield could be used in interest rate swaps.
Finally, as Ethereum co-founder Vitalik Buterin has emphasized, in some cases, a major failure of the refactoring mechanism could threaten Ethereum's underlying consensus protocol. If the amount of ETH re-held is large enough relative to all ETH held, there could be economic incentives to execute bad decisions that could destabilize the network.
in conclusion
Eigen Layer's renaming protocol is expected to become the cornerstone of various new services and middleware on Ethereum, which in turn can provide a meaningful source of ETH rewards for validators in the future. From EigenDA to Lagrange's AVS can also greatly enrich the Ethereum ecosystem itself.
That said, adopting LRT wrappers around base protocols could result in the hidden risks of opaque re-staking strategies or temporary dislocation from the base protocol. It remains an open question how different issuers choose which AVS to issue, and how to allocate risk and rewards to LRT holders. Additionally, initial yields on AVS may not meet the extremely high expectations set by the market, although we expect this to change over time as AVS adoption grows. Nonetheless, we believe that re-staking supports open innovation on Ethereum and will become a core part of the ecosystem’s infrastructure.
